Monday, December 2, 2013

From LIBOR to Fed Funds: 5 facts about the interbank lending market in the US

Contracts worth hundreds of trillions - ranging from corporate loans to mortgages to rate swaps and LIBOR futures - are all priced based on a relatively small unsecured interbank lending market. Also a fairly large group of contracts (in the trillions) is linked to the fed funds rate, which is derived from the bank-to-bank loan market as well. Given its importance, here are some facts about the interbank lending market in the US.

1. The volume of unsecured loans among US banks has collapsed in recent years. Banks fund themselves with deposits, bonds, repo, commercial paper, etc. After the 2008 experience, borrowing from other banks is rarely a material part of banks' funding strategy. The situation in Europe's interbank markets is even worse.

Interbank loans outstanding

2. While most of the LIBOR-based contracts are linked to the 3-month rate, the bulk of the interbank market on which these contracts are based is overnight. It is rare to see banks lending to each other for more than a week or two. This is the main reason that some trading desks were able and incentivized to manipulate the LIBOR index (1-3 month lending market often just didn't exist).

3. Some may find this a bit confusing but the overnight LIBOR rate and the "fed funds effective" rate are two different ways of measuring essentially the same thing: the rate at which banks lend dollars to each other overnight. The reason for the differences in the two indices is the universe of banks and the methodology used to determine the averages.

Red = Fed Funds Effective; Blue = O/N LIBOR

4. The largest lenders in the US overnight unsecured market are not even commercial banks. According to the NY Fed, most overnight liquidity is provided by the Federal Home Loan Banks (FHLBank System), which are government-sponsored entities (h/t Kostas Kalevras - @kkalev ). Unlike regular US banks, FHLBs receive zero rate on the reserve cash with the Fed. That's why they tend to lend their cash out to banks overnight at 7-12 bp (which is still better than zero). That is also why the fed funds rate and the overnight LIBOR are significantly lower than the 25bp paid on reserves.

And here is the kicker. Some privately owned commercial banks borrow these funds from FHLBs and often leave them on deposit with the Fed at 25bp. This spread between the interest on reserves and the interbank loan rate (fed funds effective) is basically free and riskless revenue for the banking system - courtesy of the federal government.

NY Fed: - FHLBs aren’t eligible to earn IOER [interest on excess reserves], they have an incentive to lend in the fed funds market, typically at rates below IOER but still representing a positive return over leaving funds unremunerated in their Federal Reserve accounts. Institutions have an incentive to borrow at a rate below IOER and then hold their borrowed funds in their reserve account to receive IOER and thus earn a positive spread on the transaction.

Source: NY Fed

5. It's enough of a problem that trillions worth of contracts are priced based on this shrinking market. Now consider the fact that the Fed's traditional tool to target monetary policy is based on the overnight interbank market where participants use government agencies to create a riskless arbitrage. And unless there is a change, the Fed will return to targeting the fed funds rate as its primary tool, once QE ends. That is why the pressure is building on the central bank to develop alternative methods (see post) for targeting short-term rates that will actually impact the broader economy.